>> Thursday, October 14, 2010

What is the most important aspect when investing?
i) Market Timing
ii) Security Selection
iii) Asset Allocation

Market timing is the attempt to predict the future by buying or selling investments in an effort to maximize profits. Many feel that this is the most important; hence, they regret not entering the market when it bottoms and exiting when it peaks.

As we all know, it is impossible to predict the future (Unless through an unfair advantage like insider information or market manipulation or just simply plain luck). These attempts will cause frustration and incur hefty transactional costs, with little profitable results over the long run.

A simple strategy would be to practice dollar cost averaging. Over the long term, the average purchased price will be lower than the average price. This is due to purchasing of more units when prices are low and less units when prices are high.

Security selection is the attempt to predict which specific security will outperform. This is normally carried out by performing fundamental analysis. Many also place great importance in this area by focusing on working out all the required financial ratios to pick the ideal security.

This poses the risk of being too narrowly focused. The selected security is not guaranteed to perform as expected and there are so many unforeseen circumstances that can affect its performance. At the same time, it is too time consuming to analyze all possible securities.

A strategy to overcome these drawbacks is to use Exchange Traded Funds (ETFs). These ETFs mirror the performance of Indexes. Index components are already determined, they are usually the more established securities and it offers diversification at low management fees.

Asset allocation involves determining the percentage of your portfolio to be spread across the various types of securities. It is an often neglected aspect but can be the most important, especially since one has full control over it.

The key to asset allocation is the correlation of the securities within your portfolio. For example, if there are 2 types of securities with low or even negative correlation, the returns will not be affected yet the risk can be minimized by combining them in the correct proportions.

In conclusion, the mass market can achieve reasonable results by determining their risk appetite, followed by allocating their portfolio wisely based on correlation into the respective type of suitable securities’ ETFs using dollar cost averaging.

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